Launching a new business requires some planning and foresight to prevent liabilities and to protect your investments. Whether you are setting up a taco trunk or launching an international manufacturing enterprise, the rules are the same. Not understanding the laws or implications of organization can leave you on the hook and cost you legal rights and financially. So, regardless of your new business venture, what do you need to know about business organization?
Here is a breakdown of your options and some pros and cons to get you started:
Sole proprietorship.
Pros: Easy to set up. How easy? You don’t have to do anything. If you don’t do anything, your venture will be considered a sole proprietorship under the law. Simply report your income on a personal income tax return. You will avoid double taxation and pay on your personal income, not on a business entity.
Cons: It sounds too good to be true because, in most cases, it is. Keeping your business as a sole proprietorship leaves you personally liable for business losses and legal obligations that may stem from your operation. That means, creditors and the government can go after your home and personal savings if your business goes awry. That money for your next vacation: gone. Your kid’s college fund: bye-bye. That is to say, no personal limited liability protection is high-risk for any business owner.
Freelancers, independent contractors, anyone who runs their own operation is going to be considered a sole proprietor. These folks pay twice the amount of Social Security and Medicare taxes as regular employees and lose out on life insurance deductions and only get a partial health insurance deduction.
In the end, most business owners will choose a legal structure with some additional protections. Others will launch a sole proprietorship and then transition to partnerships or limited liability companies as their businesses grow. Read on…
Partnership
Say you want to go into business with your brother, your mom, your college buddy, whatever, you’re going to want to know the pros and cons of a partnership. Any business with more than one owner will be considered a partnership by the IRS. Even though you don’t need to do anything formal to create a partnership, you will want to discuss some key issues with your business partner or partners, including how to split profits, how to sell shares of the business, and business succession or what happens if one partner is incapacitated, dies, or simply wants out.
Pros: One of the primary benefits of a partnership is avoiding double taxation. This means that all income will be taxed proportionately to each partner who files on their personal tax returns. You will not pay any direct taxes on your business and the tax liability will be on the owners.
Cons: Like a sole proprietorship, a partnership does not give you liability protection, meaning that any legal obligations and financial liabilities could put your personal assets and investments at risk, however, you still have options under a limited partnership or a limited liability company.
Limited Liability Company
You’ve seen the “LLC” before, but may not know the significance it carries. Any company with the letters “LLC” in the name is a limited liability company, giving additional legal protections to the owner or owners. The LLC legal structure insulates sole proprietors and partnerships against personally liabilities for business activities. Basically, this means that if someone slips and falls on your property, you are named in an employment lawsuit, or if creditors come after your business, you cannot be held personally liable for any violations, liabilities, or losses.
Pros: Again, the primary benefit is the personal limited liability which insulates owners against lawsuits and debts. You will also double taxation that comes with incorporation. An LLC can have more than seventy-five members.
Cons: You cannot issue stock or engage in corporate income splitting to lower tax liability. LLCs are entities of the state, so any legal protection depends on the given rules in the state where the LLC was formed. Any members of an LLC are subject to self-employment taxes for Social Security and Medicare.
“S” Corporation
Corporate formations are the best way to protect owners and shareholders against lawsuits. U.S. courts have determined that corporations are separate legal entities from owners, preventing litigants from going after the personal assets and investments. You may want to consider a corporate formation if you have employees or if the nature of your business gives rise to potential lawsuits. In a corporate formation shares of stock represent a portion of ownership and profits are split among shareholders. Most corporations are private entities, with stocks sold privately, not traded on the pubic stock market.
Pros: The primary difference between an S corporation and a C corporation is that the S corporation uses the same “pass through” taxation as an LLC. Shareholders maintain personal limited liability, meaning they cannot be held liable for any debts or losses.
Cons: The formation and maintenance of an S-corps can create an ongoing expense. Laws cap the shareholder number at 75, meaning that most publicly held companies are C-corps. Shareholders and those with five percent or more in stock will have limited employee benefits.
“C” Corporation
Small business owners often opt to incorporate, despite the expense and sheer amount of government paperwork. If you are a business owner considering incorporation, there are a number of practical and legal steps. First, you must form a board of directors made up of owners and non-owners. The board can be made up of any individuals, including family or friends if you want to keep your circle close. To incorporate a business, you must also file Articles of Incorporation in your desired state of incorporation. Pay attention to state requirements and fees.
Pros: You can issue stock shares to attract investors. Shareholders of a corporation have limited personal liability. Businesses can also deduct health insurance premiums and group life insurance. Tax rates are also lower for corporations than what sole proprietors or partners would pay on their individual tax return.
Cons: C corporations are subject to double taxation. This means that taxes are first paid on business profits and later, owners/shareholders will pay tax on income, distributions, and dividends derived from the corporate entity. Shareholders cannot deduct any business losses.
Many new business owners rush through the planning process without having a clear understanding of their rights or obligations. Before launching a new business or if you are a small business owner, take the time to understand the pros and cons of business formation to protect your legal rights and investments. Keep in mind that state laws will likely impact what formation to choose and where to incorporate.
